The credit crunch is a process of de-leveraging. There are some companies, banks, banking systems and countries with excessive leverage and some without. Broadly speaking, aside from Eastern Europe and Russia, emerging market companies do not have excessive leverage and, importantly, banking sectors are sound.
Rather than having the credit crunch disease, emerging markets are suffering collateral damage, mainly in the forms of reduced export demand and capital cut-off. But emerging markets have been cut off from capital many times before. And exports are not the only source of aggregate demand. The absence of banking crises means emerging markets are likely to recover before developed countries – banking crises tend to add around two years or suppressed growth before recovery.
By emerging market special situations we mean both distressed debt and private equity. In the days of marked macro-economic risk in emerging markets, distressed debt was the main focus. Following a crisis one would typically restructure sovereign debt, then banks and utilities which needed not to fail and which, in the absence of the foreign investor, would otherwise be a drain on taxpayers; then other companies with debt overhangs.
As many emerging markets have now graduated to net creditor status, have huge reserves, fiscal surpluses and are in many cases much healthier risks than some G7 countries, so the opportunity set has moved from distressed debt to private equity type transactions. Though as in the developed world this is currently complemented by distressed sellers of good assets.
Importantly a significant difference to developed world private equity is the lack of leverage employed or needed in the deals. It is also advisable to be constructive in approach, trying to solve problems working with local partners. We are seeing strong deal flow, and this includes many opportunities not being shown to other potential financial partners, avoiding competitive bidding situations. Exit strategy is also highly diverse and need not depend on an IPO market.
The biggest barrier to entry for asset managers wanting to enter emerging markets is the time and commitment it takes to build strong relationships and credibility with emerging market entrepreneurs and decision makers. Nowhere is this truer than with special situations private equity. The focus on relationships, not formula, argues for a different approach to deal-making than in developed markets.
In 2009 there will likely be many opportunities to buy assets at distressed prices, though the best opportunities will lie where one already knows the companies and where systemic banking risks are absent.
In much of the developed world there may be substantial increases in default rates, not just a result of corporate leverage and inability to refinance, but also as sales drop precipitously and unexpectedly. Emerging markets are seeing the same sort of discounts but without some of the risks. The adjustment period of consumers and householders is expected to take longer in developed countries than emerging, not least as the crisis is not one experienced by the current generation in the richer countries.
All countries are risky. Emerging ones are where this risk is priced in. As the whole world becomes emerging, the ones already there have an advantage.
Jerome Booth is the head of research and a senior member of the investment committee at Ashmore Investment Management.